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Monday, November 21, 2011

Greater intervention by the ECB raises more problems than it solves

Over on the FT A-list we've got a response to a piece by George Soros and Peter Bofinger, who are calling for the ECB to act as full lender of last resort to struggling eurozone member states. As regular readers of our blog and comment pieces will know, we're firmly against this course of action, as we believe it would throw up huge questions over the credibility and independence of the ECB (both vital if the eurozone has any hope of surviving). It would also likely make Germany question its membership in the eurozone. See below for our full response (we'd recommend reading the Soros and Bofinger piece here as well):

George Soros and Peter Bofinger present a measured approach for the intervention of the European Central Bank in eurozone bond markets, essentially envisioning it as a temporary liquidity provider of last resort. However, the ECB is already playing this role to a large extent. It has along with the eurozone bail-outs bought European politicians 18 months in which to devise the fiscal rules and growth strategy the authors call for. Unfortunately, leaders have repeatedly failed to reach any semblance of consensus on a lasting solution to the crisis.

Therefore, the exit strategy envisioned here for the ECB is dubious. Without a clear mechanism for winding down the ECB bond purchases, it becomes impossible to imagine a situation where the ECB could end its bond buying programme without causing huge market distortions.

The authors approvingly cite the example of the unlimited liquidity provision given to banks. However, this could equally be used as an illustration of the risks mentioned above. Although the ECB’s unlimited liquidity provision for the banking sector may have avoided a bank run, it simultaneously created a set of so-called ‘zombie banks’. Precisely because of the absence of an exit strategy, these banks have now become reliant on ECB liquidity to survive, while stripping them of the incentive to reform the bad practices and mismanagement which got them into this situation in the first place. The cost of this is now becoming clearer, with some banks on the precipice of failure, forcing a widespread recapitalisation of the banking sector – of which some cost will undoubtedly fall onto taxpayers. Against this backdrop, it becomes a huge risk for the ECB to stake its independence and credibility on the hope that such a solution will be achieved in the near term.

Targeting the spread between German bunds and other eurozone bonds would also significantly undermine the ECB’s independence. Ultimately, the spreads are reliant on the fiscal policy and domestic politics of each member state. Any failure or uncertainty in either area spooks markets. As such, the level of ECB bond buying could become almost directly influenced by the political and policy decisions in member states. The ECB is already treading perilously close to this line. One step further and it would cease being the independent central bank that is so essential to future monetary stability, and instead become a fiscal actor highly susceptible to political wrangling.

This also raises questions over the definition of the bond run. It’s true that the yields may not currently accurately represent the economic fundamentals of each nation, however they are a result of the markets trying to price in the domestic and European political risk as well as the structural flaws in the eurozone exposed by the current crisis. Using the ECB to try to ‘correct’ these issues not only damages the price determination mechanism in markets but takes the ECB far beyond its mandate.

Moreover, the German fears over hyperinflation cannot be seen as an anomaly – it is a political reality that goes to the heart of the German post-world war settlement. The day the ECB is turned into a politicised lender of last resort, may also be the day when the Germans start to seriously question whether they wish to be a part of the single currency.

The struggling eurozone countries need to press ahead with economic and institutional reform. But in the longer term it has now got to the point where the eurozone will have to reassess its structure and membership if it is to survive. Having the ECB act as a full lender of last resort will detract from these requirements and may throw up more problems in the longer term; making it ultimately self-defeating.

2 comments:

- if you treat the liquidity crisis (as Soros prefers), by providing an unlimited backstop, you create moral hazard by rewarding profligate countries, and those who lend to them. This makes the solvency crisis worse.

- if you treat the solvency crisis (as you prefer) by punishing profligate countries and their lenders, you make the liquidity crisis worse.

The only available solution to a combined liquidity & solvency crisis is default & devalue (cf Argentina, Iceland). The politicians have ruled this unaccpetable, but have failed to provide any other solution.

The Cornish bloke has got this right. This is a solvency crisis, currently for the PIGIS and Cyprus and Belgium. They can only grow out of it outside the Euro. The longer they stay in the Euro, the more it will become a solvency crisis for the 'strong' countries. Austria and France are already feeling the cold wind blowing. And how much does Germany really have to offer? Their deficit is as bad as anyone's, if you take into account their pension black hole.